Can an LLC Have W-2 Employees? Rules and Requirements

A Limited Liability Company (LLC) can hire W-2 employees. This business structure is known for providing a liability shield to its owners. A W-2 employee is an individual who works for an employer, where the employer is responsible for withholding and remitting payroll taxes on their behalf.

Determining if LLC Owners Can Be Employees

Whether an LLC owner can be a W-2 employee depends on the business’s tax classification with the Internal Revenue Service (IRS). This tax election dictates an owner’s role and how they are compensated.

By default, the IRS treats a single-member LLC as a sole proprietorship for tax purposes. In this scenario, the owner cannot be a W-2 employee and does not receive a salary. Instead, the owner takes compensation through an “owner’s draw,” which is a withdrawal of funds from the business’s profits for personal use.

A multi-member LLC is taxed as a partnership by default. Similar to a single-member LLC, the owners cannot be classified as W-2 employees. They receive their compensation in the form of “guaranteed payments” for services rendered or as distributions of the company’s profits. These payments are reported on a Schedule K-1 and are subject to self-employment taxes on the owner’s personal tax return.

An LLC can elect to be taxed as an S Corporation by filing Form 2553 with the IRS. If this election is made, any owner who provides substantial services to the business must be treated as a W-2 employee. This means they must be paid a “reasonable salary” that is subject to standard payroll tax withholding. A reasonable salary is what similar businesses would pay for comparable services, a measure intended to prevent owners from avoiding payroll taxes by taking all compensation as distributions.

Alternatively, an LLC can choose to be taxed as a C Corporation. In this structure, owners who actively work in the business can be treated as W-2 employees and receive a salary. The LLC, now taxed as a separate corporate entity, pays taxes on its profits, and the owner-employees also pay personal income tax on their wages.

Initial Steps for Hiring W2 Employees

Before an LLC can hire W-2 employees, it must complete several foundational steps for legal and tax compliance:

• Obtain a Federal Employer Identification Number (EIN) from the IRS. This nine-digit number functions as a Social Security number for the business and is required for any company that hires employees.
• Register with the appropriate state-level agencies. This involves registering with the state’s workforce or labor department for State Unemployment Tax Act (SUTA) taxes and the department of revenue to manage state income tax withholding.
• Have the employee complete Form I-9, Employment Eligibility Verification. This form is used to verify the employee’s identity and legal authorization to work in the United States.
• Have the new employee fill out Form W-4, Employee’s Withholding Certificate. This document provides the employer with the information to determine the correct amount of federal income tax to withhold from the employee’s wages.

Employer Payroll Tax Responsibilities

When an LLC hires W-2 employees, it becomes responsible for several payroll taxes. These include taxes withheld from an employee’s pay and taxes paid directly by the employer. The Federal Insurance Contributions Act (FICA) tax funds Social Security and Medicare. This tax is split evenly between the employee and the employer, where the employer withholds the employee’s share and pays a matching amount.

The Social Security tax is levied at a rate of 6.2% for both the employer and the employee, on wages up to $176,100. The Medicare tax is 1.45% for both parties on all of the employee’s wages, with no wage cap.

Employers are also tasked with withholding federal income tax from each employee’s paycheck. State and local income taxes must also be withheld according to the regulations of the jurisdictions where the employee works.

Unemployment taxes are typically paid solely by the employer. The Federal Unemployment Tax Act (FUTA) requires employers to pay a tax that funds federal unemployment programs. The FUTA tax rate is 6.0% on the first $7,000 of wages paid to each employee annually, though employers can often receive a credit of up to 5.4% for paying state unemployment taxes on time, effectively lowering the rate to 0.6%. State Unemployment Tax Act (SUTA) taxes are paid directly to state workforce agencies to fund state-level unemployment benefits.

Managing Payroll and Filing Requirements

An LLC must establish a system for managing payroll and meeting regular filing deadlines. A part of this process is depositing the withheld federal income taxes and both the employee and employer shares of FICA taxes. These deposits are made electronically through the Electronic Federal Tax Payment System (EFTPS). The frequency of these deposits, either monthly or semi-weekly, is determined by the total tax liability reported during a specific lookback period.

To report these taxes, employers must file Form 941, Employer’s QUARTERLY Federal Tax Return. It is due by the last day of the month following the end of each quarter: April 30, July 31, October 31, and January 31.

For federal unemployment taxes, employers file Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return. While the form is filed once a year, deposits may be required quarterly if the FUTA tax liability exceeds $500 in any given quarter.

At the end of the calendar year, the employer has additional reporting duties. Each employee must be provided with a Form W-2, Wage and Tax Statement, by January 31 of the following year. The employer must also file copies of all employee W-2s with the Social Security Administration, accompanied by a Form W-3, Transmittal of Wage and Tax Statements, which summarizes the totals from all the W-2s being filed.